April 25 – Fitch Ratings believes timing and price are key when it comes to
the pace at which Morgan Stanley (MS) will acquire Citigroup’s remaining
stake in brokerage Smith Barney (SB).
MS already owns 51% of the business and beginning next month has the option to
buy 14% (roughly one-third) of Citi’s remaining 49% share and two more options
to buy the remaining share through May 2014. If MS feels that prospects for the
brokerage business over the next few years will be more advantageous than the
current SB valuation implies, we believe they could look to buy at what, from
MS’s point of view, is an attractive valuation. Additionally, if MS is
experiencing too much volatility in their other business lines, including sales
and trading, it could explore the possibility of acquiring it sooner as a way to
diversify and/or stabilize earnings.
With that said, we believe a 14% purchase is the most likely scenario. Greater
ownership of the joint venture in the near term and full ownership over time
will improve MS’s revenue and earnings mix, which is currently heavily weighted
toward the institutional securities business. The institutional securities
segment is by far the largest driver of firmwide performance but is also subject
to considerable challenges should market conditions become more difficult. We
note the MSSB business is also less volatile and far less capital intensive,
particularly under Basel III. And while current earnings contribution from MSSB
are relatively low, that could grow meaningfully over time if management reaches
projected operating margin growth as systems integration is completed this
summer.
In addition, we believe MS will gain incremental deposits from customers of MSSB
as its ownership percentage increases, helping MS far more than it would hurt
Citi, given Citi’s far larger overall depository franchise.
While we believe the purchase is more likely to occur in pre-specified
intervals, if MS elects to buy the entire remaining share, Citi must be willing
to sell it. Citi stated in its latest earnings call that its investment in the
joint venture is in holdings and not part of its core operations, so by
definition it is looking to exit that business. Citi’s CEO also said they have
“plenty of time” to consider the sale.
We note that Citi would clearly benefit from the sale in the form of capital
relief, as under Basel III, the stake in the joint venture is directly deducted
from Tier I capital. However, we believe the bank will be able to meet Basel III
excluding the sale, considering Citi’s estimated Basel III Tier I common ratio
is 7.2, with a target of 8.0 by year-end 2012.
